The Fed Has Blocked off Every Southbound Lane on the Road to Price Discovery

“But the systemic cracks we’ve been closely monitoring,” he warns, “definitely got an awful lot wider [last] week… The central banks have distorted the processes of price discovery and market structure for so many years now that it’s difficult to know yet whether their grip on the markets has indeed failed.”

We agree, it is difficult to know.

For years the Fed has blocked off every southbound lane on the road to price discovery… and detoured all traffic into one single lane heading north.

But chief traffic engineer Jerome Powell has lifted some of the restrictions…

He has continued to raise interest rates. He is also working down the balance sheet.

Between Sept. 6 and Oct. 3, the Fed lopped off $34 billion of market-supporting assets.

In all, quantitative tightening has taken roughly $285 billion off duty since October last.

“We’re transitioning from a market led by central banks to one where fundamentals dominate,” says Mohamed El-Erian, chief economic adviser at Allianz.

But what if the fundamentals aren’t equal to the job?

Some 165 companies of the S&P 500 — roughly one-third the index — now tread in bear market territory.

Meantime, Investor’s Business Daily tracks 197 industry groups… 194 of them are in retreat this month.

“It tells you how much real weakness there has been,” says Gary Kaltbaum, president of Kaltbaum Capital Management.

But we opened by raising the possibility of Dow 40,000.

If it can’t hold the line at 26,000, you ask… how 40,000?

Yves Lamoureux is president of macroeconomic research firm Lamoureux & Co.

In January 2016 — when the Dow Jones traded in the vicinity of 16,500 — he ventured the index would scale 25,000 within a few short years.

It did.

Now this fellow is coming out flatfooted for Dow 40,000.

But recall… there was a catch along the way…

That catch takes the form of a “large panic event” beginning now and running through to next year.

Investors Should Be out of Stocks for Most of 2019

Mr. Lamoureux:

We see a large panic event taking shape now that continues into next year — the melt-up we forecasted is done. Investors should be out of stocks for most of 2019.

He hazards the stock market could shed perhaps one-third its value in the unfolding panic.

From today’s perch, a 33% decline represents an 8,471-point bludgeoning.

But by 2020, Lamoureux projects the Dow Jones will rise again… as if by conjury.

But how? What unseen force will provide the magical effect?

The Federal Reserve.

Will the monetary authority slash rates to zero… and hatch another round of quantitative easing?

Most likely it will — but the Fed has depleted too much of its phony fireworks in the last crisis to work next time.

As Jim Rickards explains:

Interest rates are still at 2.25%, whereas they need to be about 5.0% to give the Fed enough room to cut rates to get the economy out of a recession. The money supply is still about $4 trillion, down from $4.4 trillion but still too high to launch more quantitative easing without the risk of destroying confidence in the dollar. In short, the Fed and other central banks are not in a position to deal with a recession or panic should one arise in the near future.

What then can it do?

This Lamoureux fellow argues the Fed will no longer support markets indirectly with its usual witchcraft…

It will instead buy stocks directly:

“The Fed most likely steps up early in 2020 and starts buying shares.”

Lamoureux believes the resulting “hyperinflation of financial assets” will lift the Dow Jones to its 40,000 crest in the years following.

Perhaps you scoff at the suggestion of the Fed buying stocks.

But we would remind you that the Bank of Japan and the Swiss National Bank are already hard at the business.

The Bank of Japan owns some 75% of the nation’s exchange-traded fund (ETF) market.

And equities comprise roughly 20% of Swiss National Bank reserves.

Were you aware that the Swiss National Bank owns substantial shares of Amazon, Apple, Facebook and Microsoft?

But comes the objection:

United States law prohibits the Federal Reserve from purchasing equities. It can only bring aboard Treasuries and mortgage-related assets.

Ah, but do not forget Cicero’s injunction:

Inter arma enim silent leges — in times of war, the laws fall silent.

And in event of financial crisis, the laws too fall silent… or are hastily rewritten.

Eric Posner professes law at the University of Chicago.

He claims, for example, that the Fed’s rescue of Bear Stearns was “legally questionable.”

He furthermore claims the Fed reached into the same “legally dubious” trick bag to bail out insurance titan AIG.

But the Fed buying stocks?

This Could do the Trick

Only last month, former IMF chief economist Olivier Blanchard proposed it before the Boston Fed’s monetary policy conference.

Blanchard argued thusly:

“[Buying stocks] could do the trick and could work even better than buying long bonds.”

Onto the balance sheet they would go.

Do you think the Fed’s balance sheet is behemoth already, even with quantitative tightening?

This Blanchard fellow does not:

“If we need it, we could clearly double it and nothing terrible would happen.”

That is, madder wine, madder music… and madder men would be the solutions on tap.

The Fed’s capture of the “free market” would thus be complete… and it would have the stock market safely under lock and key.

And so we close by repeating the old chestnut from G.K. Chesterton:

“The modern world is insane, not so much because it admits the abnormal as because it cannot recover the normal.”

About Brian Maher:

Brian Maher is the Daily Reckoning’s Managing Editor. Before signing on to Agora Financial, he was an independent researcher and writer who covered economics, politics and international affairs. His work has appeared in the Asia Times and other news outlets around the world. He holds a Master’s degree in Defense & Strategic Studies.